Abstract

The failure of covered interest parity (CIP), or, equivalently, the persistence of the cross currency basis, in tranquil markets has presented a puzzle. Focusing on the basis against the US dollar (USD), we show that the CIP deviations are closely associated with the demand to hedge USD forward, and the capacity of the respective banking systems to intermediate FX hedging imbalances. Fluctuations in FX hedging demand exert significant effects on the pricing of forward exchange rates because of the re-pricing of balance sheet capacity by financial institutions. In particular, banks take account of the potential losses on their FX derivatives book, which necessitates approaching CIP arbitrage as a risky exposure. As a result, the aggregate supply curve for FX hedges via currency swaps has become upward-sloping. We find that CIP no-arbitrage bounds are endogenous to the amount of FX hedging imbalances, which explains the persistence of cross-currency basis; while short-term fluctuations of cross-currency basis largely reflect changes in funding and market liquidity conditions.